How to use the Average True Range (ATR) Indicator : Price Analyses

How to use the Average True Range (ATR) Indicator

The average true range (ATR) is a volatility indicator that has many useful applications in trading, including forex. The ATR can help you plot profit targets, set trailing stop losses, and gauge the overall strength of the trend before entering a position.

The ATR changes depending on the price changes of a given security. The indicator shows the true range measured as an absolute value. For example, a security with a $10 ATR on a 4-hourly chart means that it moves, on average, $10 every four hours.

The application of the average true range and how it can improve your trading performance is what we’ll explore in this article.

average true range line

Your Average True Range (ATR) Quick Facts:

  • The ATR is first based on true ranges and then smoothed over 14 periods.
  • True ranges helps us see the degree of interest from buyers and sellers for certain price movements.
  • Overbought and oversold positions can be determined by the ATR if the price moves significantly above or below the ATR value.
  • There are various kinds of overlays for the ATR that can be used to quickly see profit-taking areas and stop-loss zones.

Average True Range (ATR) Formula and Calculation

The ATR is calculated as the following:

  • Most recent period’s high minus the most recent period’s low
  • Absolute value of the most recent period’s high minus the previous close
  • Absolute value of the most recent period’s low minus the previous close

The formula for the indicator is as follows:

How to use the Average True Range (ATR)

The ATR can be configured as either a line with its own series or overlaid onto the graph itself as average true range bands.

average true range bands

Here’s how you can incorporate the above ATR setup in your trading strategy. And note that you can access this overlay and others for free using TradingView.

It all comes down to probabilities.

If the ATR value is $10 on the 4-hour chart then movements above and below this amount are likely to revert back to the $10 average. You can see the average in the chart above as the purple line running through the candlesticks – notice how prices seem to be attracted to this middle ground?

Average True Range Interpretation

If the ATR for your trade is $10 and the current price is $11, then more likely than not the price will revert back to its mean of $10 than go higher. In this position, you’re better off shorting than going long.

Likewise, a security valued at $9.50 with a $10 ATR is more likely to rise than to dip lower. Keep in mind, however, that the ATR can only do so much. You should also look for signals from both momentum, volume, and the overall trend before opening a position.

The ATR can serve as confirmation that the price is more likely to go higher or lower than your entry price. When used effectively, the indicator can help set you up for more profitable trades with less risk.

Average True Range Trailing Stop Loss Strategy

Here’s a handy overlay I found on TradingView that shows where you should be setting your stop losses when using the ATR. Below is a community submission by the user Sylvain Vervoort.

average true range stop loss

The stop losses are automatically calculated to be below the ATR.

You can take this strategy a step further by using a trailing stop loss. If your software supports it, a trailing stop loss moves as price changes, which is set to lock in a profit for you and protect your initial investment. For instance, a $11 trailing stop loss on a trade worth $13 would go up to $12 if the price moved to $14. It would also follow when the price decreases.

Finding Profit Targets

The final way that the ATR can help you trade is through calculating profit targets based on true ranges.

atr profit target

The chart above shows you the potential buy and sell zone areas calculated as a true range. The purple areas represent shorting opportunities while the green is your profit zone.

Average True Range Summary

The ATR can help you measure the volatility in the marketplace, which is useful for determining entry and exit points as well as setting up a stop loss to protect your initial investment.

As prices have a tendency to revert back to the mean, it’s assumed that prices will eventually come back to this middle ground despite temporarily breaking out from its price formation.

Matthew North

I have a passion for trading, behavioral finance, technology, travel, and writing. Contact: matthew@priceanalyses.com.

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